Impact of Taxation and Inflation on Financial Management

In this article we will discuss about the impact of taxation on corporate financial management.

Impact of Business Taxation:

The tax payments represent a cash outflow from the business and therefore, these tax cash flows are critical part of the financial decision making in a business firm. In deed in some practical situations, the taxation implications are dominant influences on the final investment decision also.

Taxation effects firm in numerous ways, the most significant effects are given below:

(a) Corporate taxes on firm’s profits.

(b) Reduction in WACC because interest payments are allowable against tax.

(c) Dividend will not reduce the tax burden of the firm since it is not a charge on profits.

(d) Where the firm incurs overall loss, it can be carried forward to a future profit making year.

(e) Where a unit of the firm incurs loss but the firm gets overall profits from all other units, loss of the loss making unit will reduce the overall tax liability of the firm by set-off of losses.

(f) Impact of depreciation provision on the reduction of taxable income.

(g) Taxation of capital gains and its impact on profits of the firm.

(h) Double taxation of firm’s earnings like dividends received from other companies and its impact on profits etc.

Financing with debt and making interest payments rather than dividend payments will generate after-tax income for the company’s suppliers of equity capital, but simultaneously there is greater risk associated with financing with debt.

The types of tax rates are given below:

(i) A progressive tax rate is a rate that escalates as the amount of income increases.

(ii) A marginal tax rate is to be applied to the next rupee of income.

(iii) The average tax rate equals the amount of tax divided by the taxable income.

Personal Taxation:

A business organization must consider the tax consequences for the investors in company’s shares, debentures and bonds in order to attract investors to the firm’s securities.

The investments in company attract two types of taxes to the investors:

(i) Earnings in the form of dividends and interest.

(ii) Capital gains from disposal of the investments.

When the investments made in tax free securities like tax free municipal bonds, will not attract any taxation on the individual investors.

Corporate Taxation:

Corporate financing means identification of funds requirement of a firm and raising of funds from various sources to meet the funds requirement of the firm.

Corporate financing sources can be broadly categorized into two:

(a) Equity, and

(b) Debt.

Equity consists of equity share capital and preference share capital. The company will distribute profits among equity holders in the form of dividends.

The dividends will be distributed only out of distributable profits i.e. profits available after payment of tax. The distribution of profits in the form of equity and preference dividends will not reduce the tax liability of the firm, since the payment of dividends is only an appropriation of profits available to the shareholders. The other form of financing company’s projects is through raising of debt.

The debt may be in various forms like debentures, bonds, term loans etc. The company will pay interest to the providers of debt to compensate for allowing the use of their resources for the benefit of the firm. The interest payment on debt is taken as a charge against company’s earnings and will reduce the profit to be taxed.

Therefore, the interest liability of the company is reduced to the extent of tax savings on profit reduced due to interest expense. The tax saving will reduce the effective cost of debt.

Since the cost of debt is lower than the cost of equity, which enables the firm in taking the advantage of trading on equity. In other words, the lower cost of debt will enable the more distributable profits available to the equity providers. However, the debt component in capital structure will cause the firm to financial risk.

Finance Manager Role as Tax Planner:

The scope of finance function extends to a variety of decisions to be taken on financing and investment activities of the organization. Financial management suggests any financial decisions should be taken in the light of maximization of wealth of owners. The payment of corporate taxes involves cash outflows and will reduce the wealth available to the shareholders.

Hence, one of the functions of a Finance manager is to act as a tax planner of the organization and to minimize the cash outflows in the form of taxes. The tax payments of a firm are categorized into direct taxes and indirect taxes. The Finance manager should have sufficient knowledge in understanding the taxation policy and provisions.

All the financial decisions should be taken, keeping in view the impact of taxation on the firm’s wealth maximization objective. The financial decisions like capital investment proposals, raising of long-term finances in equity and debt, tax incentives in setting up of a project, tax implications on lease or buy decisions, distribution of dividends and personal taxation of shareholders, impact of depreciation on tax payments, capital gains on sale or disposal of fixed assets etc. should be taken after taking into account the impact of taxation and its financial burden on the firm.

Tax Shield:

The dividends payable to equity shareholders and preference shareholders is an appropriation of profit, whereas the interest payable on debt is a charge against profit. Therefore, any payment towards interest will reduce the profit and ultimately the company’s liability towards taxes would decrease. This phenomenon is called ‘tax shield. The tax shield is viewed as a benefit accrues to the company which is geared.

To gain the full tax shield the following conditions apply:

(a) The company must be able to show a taxable profit every year to take full advantage of the tax shield.

(b) If the company makes loss, the tax shield goes down and cost of borrowing increases.

Tax Planning and Tax Avoidance:

Tax Planning:

Tax planning implies scientific planning of one’s operations in such a way as to attract a minimum liability to tax or deferment of the tax liability for the subsequent period by availing of various incentives, concessions, allowances, rebates and reliefs provided for, with the applica­tion of expertise with a view to securing the tax benefits legally provided for in law. It does not imply availing of undue advantage of loop-holes in tax laws of evading tax liability. Tax planning may be legitimate provided it is within the framework of law. Colourable devices cannot be part of tax planning.

Tax Avoidance:

It is the act of dodging tax without actually breaking the law. It is a method of reducing incidence of tax by taking advantage of certain loopholes of tax laws which the legislature didn’t intend to provide. It may be difficult to distinguish a loophole from an intended benefit through perhaps an interpretation beneficial to a single assesse may turn-out to be a loophole in general. Tax avoidance is nothing but tax dodging, if it defeats a clear objective of law.

Impact of Inflation:

Financial management is basically concerned with acquisition, financing and management of assets of business concern in order to maximize the wealth of the firm for its owners. The inflationary situation will have direct impact on the financial decisions. Financial accounts are the basis on which investors rely upon for their safety of investment, as well as, to obtain reasonable return on their investment.

But the financial information shown in the financial statements, drawn as historical accounting basis, is mutilated due to inflation. During the periods of inflation profit is overstated and the value of closing inventories is exaggerated and results in acute shortage of funds. The inflationary situation is beyond the control of Finance manager, but he should revise and modify the financial policies to counter the adverse effects of inflation.

The impact of inflation on various financial decisions can be studied in the following heads:

(a) Investment Decisions:

During the periods of inflation there will be escalation in project cost and in turn will have impact on future profitability of the concern. The future cash flows have to be re-casted and its impact on capital budgeting decisions should be measured qualitatively. Sometimes, inflation may cause to abandon the projects under implementa­tion.

(b) Financing Decision:

The cost of capital will be more during the periods of inflation. The providers of debt, as well as, equity capital require more return to part with their funds. The funds required for working capital finance would be more. The Finance manager should be able to evaluate the requirement of funds during periods of inflation and should assess the revenue generation capability of the concern in meeting its operating costs, as well as, reasonable return on the funds raised.

(c) Dividend Decisions:

Dividend paid represents a cash outflow which depletes the cash resources. The dividend decision is regarded as a financing decision since any cash dividend paid reduces the amount of cash available for investment by the firm. In case of high inflation conditions, the fixed assets are generally replaced with the retained earnings rather than raising external finances.

In times of inflation, the external funds are costlier, a firm may resort to low dividend payment and use the internal funds for financing its business. During periods of inflation, the depreciation provided on historical cost basis would not be sufficient for replacement of fixed assets at the end of their economic life.